The U.S. Federal Reserve is widely expected to cut interest rates on Tuesday by at least a quarter-percentage point to fortify the economy against a credit crunch and housing slump that some economists fear could bring a recession.

Steady if unspectacular hiring and signs the consumer has yet to fold suggest the economy, while cooling, has not entered a precipitous slide. At the same time, deteriorating conditions in financial markets recently led the Fed to make clear it saw risks rising and was ready to respond.

They now believe the dysfunctional credit markets present more risk to the economy and the financial system than anything found in the economic or inflation statistics, economists at financial services giant Wachovia wrote in a note to clients.

For the time being, the Fed will focus on righting the financial markets and making sure there is enough stimulus in place to offset the tightening in credit markets and ongoing unraveling of the housing market, they said.

The U.S. central bank meets against a backdrop of widespread unease over the sagging housing market and deepening gloom over exposure to delinquent mortgages at major financial institutions around the world.

Financial markets are betting the Fed lowers the benchmark federal funds rate by a quarter-percentage point to 4.25 percent from its current level at 4.50 percent, and think a surprise half-point reduction is not out of the question.

At its last meeting on October 30-31, the central bank lowered rates by a quarter point, following up a surprisingly large half-point reduction in September. At the time, the October easing was a close call, minutes of the meeting released later said, because evidence of a pronounced weakening of the broader economy was not evident to all policy-makers.

RIVERS OF RED INK

But since that decision, money center banks like Citigroup (C.N: Quote, Profile, Research), Bank of America (BAC.N: Quote, Profile, Research), and HSBC (HSBA.L: Quote, Profile, Research) have announced billions of dollars worth of write-downs due to exposures to subprime mortgages. As financial market angst has spread over the extent of subprime problems, credit availability has stiffened, fueling heightened worry at the Fed.

These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors, Fed Chairman Ben Bernanke said on November 29.

So far, outside of the housing and financial services sectors, the U.S. economy has exhibited resilience. In addition to a steady labor market, many retailers reported stronger-than-expected November sales and a slumping dollar helped boost demand for U.S. exports.

Also, the risk of a flare-up in inflation -- which the central bank had cited as a reason for monetary restraint even as financial markets clamored for rate cuts -- appears to have eased slightly. Productivity has been strong and core inflation gauges, which exclude volatile energy and food costs, have remained tame.

However, after a period of relative calm, credit markets are showing a level of strain not evident since August, when mounting defaults on U.S. subprime mortgages first led to a worldwide pullback in money markets.

Interbank lending rates soared to nine-year peaks at the start of this month as banks rushed to secure cash for the new year. Also, interest rates on U.S. Treasury bills slipped to August lows last week as investors sought safe money havens.

As a result, heightened financial market uncertainty opens the door for the inflation-wary Fed to acknowledge that risks are now tilted toward a stumble in growth.

Market turmoil also leaves the door ajar for a half-point cut in the interbank federal funds rate. If policy-makers opt to trim that rate by just a quarter point, they could try to unlock credit flows by offering a larger cut in the discount rate the Fed charges for direct loans to banks.

(Editing by Jan Paschal)

Inflation Ben Bernanke Wachovia